The SEC Caves on China: An exemption for Chinese auditors puts U.S. markets at risk.

The SEC Caves on China: An exemption for Chinese auditors puts U.S. markets at risk.

Feb. 26, 2015 11:12 a.m. ET

U.S. stock-market regulators say they promote transparency and fair play, but this month the Securities and Exchange Commission quietly carved out a China-size exception: When Chinese companies list on U.S. markets, basic auditing rules won’t apply.

Why? Because China’s government doesn’t want them to, and Washington bent to Beijing’s pressure. The SEC has long sought access to the auditing records of Chinese companies suspected of fraud. Tens of billions of dollars in U.S. market value have disappeared in recent years as more than 170 U.S.-listed Chinese companies have faced scrutiny for embezzlement, theft, misrepresentation and other alleged abuses.China-based auditors have refused to comply with SEC subpoenas for their clients’ paperwork, citing Chinese laws that treat such corporate information as state secrets. These laws, always vague and often harshly enforced, are a classic authoritarian tool for masking the political interference, graft and opacity endemic to China’s economy.

In 2012 the SEC filed charges against the Chinese affiliates of the Big Four audit firms, KPMG, PricewaterhouseCoopers, Ernst & Young and Deloitte. “Only with access to work papers of foreign public accounting firms can the S.E.C. test the quality of the underlying audits and protect investors from the danger of accounting fraud,” enforcement chief Robert Khuzami said at the time.

Last year SEC Administrative Judge Cameron Elliot ruled that the auditors were “willfully violating” U.S. regulations by refusing to turn over client information. China’s secrecy rules are no excuse, he wrote, because the auditors and their clients freely chose to list in the U.S. under SEC regulation: “To the extent the [firms] find themselves between a rock and a hard place, it is because they wanted to be there. A good faith effort to obey the law means a good faith effort to obey all law, not just the law one wishes to follow.” He suspended the auditors from practicing before the SEC for six months, pending appeal to the SEC Commissioners.

Judge Elliot’s decision appeared to point the way toward a U.S.-Chinese diplomatic compromise, as both countries would feel some pain if the auditors’ suspension from the U.S. was affirmed. Chinese companies would have to delist from U.S. exchanges and relist in less familiar and less sophisticated markets overseas. Bankers and lawyers on Wall Street would lose some fees, and U.S. firms operating in China would have to adjust their own relationships with auditors and the SEC. So officials had good reason to balance Chinese sensitivities over “secrecy” with U.S. concerns about accounting fraud.

But the result is a cave-in, not a compromise. SEC Commissioners decided this month not to suspend the Chinese audit firms or penalize them beyond token fines of $500,000—less than an average partner’s salary. In return, the firms agreed to follow certain procedures for conveying audit information to the SEC through Chinese state regulators. Yet Chinese authorities aren’t even a party to the settlement, so they remain as free as ever to stymie future investigations.

The upshot is that investors in U.S. capital markets still lack basic protections against Chinese fraudsters. And the financial stakes are rising. Chinese firms now account for hundreds of billions of dollars of U.S. market value, led by e-commerce giant Alibaba , which last year raised $25 billion in an initial public offering.

If the SEC is unwilling to enforce a level playing field among auditors working around the world, it could at least do more to flag risks for the market. On China’s stock exchanges in Shanghai and Shenzhen, domestic regulators have branded some stocks for “special treatment” if their earnings and accounting practices suggest particular risk. The SEC could adopt similar labels for the stocks of any U.S.-listed companies—Chinese or otherwise—that are unable or unwilling to share their audit records.

China’s official Xinhua news agency says the SEC decision proves that Chinese auditors are “too big to ban.” That’s bad enough for U.S. capital markets. The greater threat, which endangers far more than stock prices, is China’s rising confidence that it can play by its own rules.

Guest Speaker Mr. Hemant Amin, Founder, Chairman and CEO of Asiamin Capital, a single family office, and Founder and Chairman of the BRKets investor groupMarch 17th, 2015

Hemant, a big thank you for educating and inspiring the next generation of leaders. You are a rare positive role model in the Asian capital markets and you showed the students that it is possible to create value because one has the right values and mindset like Buffett and Munger! :)